Craziness
Today, Sanity Tomorrow
John Riley
Chief Strategist
04/01/08
Let’s
take a look at some of today’s headlines:
Doubts
Greet Treasury Plan on Regulation
US Corporate Bonds Sales Fell 32% in the First Quarter
Banking Industry to Cut 200,000 Jobs
Banks Face Biggest Crisis in 30 Years
UBS to Write Down An Additional $19 Billion Related to US Real Estate
Chrysler March Sales Down 19.4%
Auto Sales Remain Weak: GM Posts 19% Drop
USA 2008: The Great Depression
This is no April
Fools joke. These were yesterday’s headlines. And the market?
Up almost 400 points. With these headlines as a backdrop, investors
decided it would be a good day to buy!
As with all
bear market rallies, and that is all the recent rally is in our
opinion, investor enthusiasm overflows into the markets with great
abandon. Investors want to know everything is going to be alright
and have a decidedly positive attitude, all the way down a bear
market decline.
Before we look
at yesterday’s action, let’s look at bear market rallies
through history.
The Crash in
1929 was not a one day, one month or even one year bear market.
It lasted almost 3 years and wiped 90% off the market.
But in the meantime,
there were several substantial and relatively long bear market rallies.
Some of the rallies lasted over 6 months and the chart above shows
some of the rallies had gains over 25%.
Unfortunately
for investors, the poor fundamentals of the economy overtook their
enthusiasm and the decline that had started in 1929 continued. Debt
was the major economic drag. It hit a peak of 270% of GDP soon after
the market’s peak in 1929. (To put this in context, today
the Debt to GDP ratio is over 300%. The ratio is under 150% in normal
times.)
Decades later,
investors were treated to the torture of the 1970’s. The Dow
Jones peaked in 1966 at 999 and didn’t get and stay above
1,000 until 16 years later in 1982. But there were some incredible
bear market rallies as the chart below shows.
Every time the
market rallied, it ran right into the poor economic fundamentals.
The major economic theme was inflation and a slowed economy. The
5 bear markets had losses of -26%, -35.5%, -45.2%, -26.4%, -23%.
Ouch. Each bear market rally was greeted by a vicious bear on the
other side.
Bear market
rallies are not just a phenomenon from the past or an American problem.
Japan’s stock market, the Nikkei, peaked in 1989 at about
40,000. It didn’t bottom until 2003, down 80%. (And only time
will tell if that bottom will hold.)
But the bear
market rallies were tremendous. One rally more than doubled the
market, two were up about 50% or more and one was up 25%.
When all was
said and done though, the rallies gave way to the deflationary trend
of the economy which was weighed down by the excessive debt burdening
their economy.
What does this
history lesson have to do with today’s market? The US economy
is faced with similar problems, but instead of just one or two,
we have all three - debt, inflation and deflation. (See Icebergs
, 12/03/07)
1 – Debt
- The debt to GDP ratio is higher today than it was in 1929.
2 – Inflation – Global demand for commodities is pushing
inflation higher.
3 – Deflation - Competition from abroad and domestically is
limiting pricing power, putting us on the verge of deflation.
We know what
the fundamental condition of the economy is. We also know that history
shows us that it takes years for these scenarios to play out. So
when investors see the market rallying, should they get excited
about the rally, or put it in the context of the underlying economic
reality?
But aren’t
the Fed’s actions fixing the problems? No. Simply put, almost
everything the Fed is doing is adding more debt to an already overburdened
economy. More debt won’t get us out of our economic mess,
it only makes it worse. (See A
$145 Billion Dollar Cup of Irish Coffee and The
Fed Buys A Round )
Below is a recap
of the market action on April Fool’s Day.
The almost 400
point gain was impressive, even explosive. But when put into context
of recent performance, it failed to break above resistance.
The trend for
the market is down and yesterday’s action doesn’t change
that. Resistance is at 12750 and support is about 11750. A move
above resistance could signal a reversal of the trend while a move
below support confirms the downtrend.
Banks and Brokers
both had big days yesterday as the euphoria of bailouts danced in
investors eyes. (Blinding them to the reality that lies ahead.)
While the single
day’s gains were exciting, the recent trend down has been
horrendous. A bounce up is always expected with downtrends like
these below.
While the banks
look like they may have double bottomed, resistance is still at
90 and then 95. Support is around 77. A break below confirms the
downtrend, a break above 95 could mean there is a reversal in the
banks. Our bet is that banks stay in a trading range for a while
until the next shoe drops.
The
Dow Jones World’s chart is still one of the scariest charts
we watch. Although it has come down a bit recently, it still has
a long way to go to its bullish trendline.
The first area
of support is about 264. The computer puts its downside target at
216. Its bullish trendline is all the way down at about 166/168.
This tells us the upside is limited to a possible trading range
while the downside is significant. This is why we have recently
added more ETF’s to hedge international equities.
Gold has been
declining for the past couple of weeks. All sorts of reasons have
been given, but the charts make it clear.
Gold raced up
to 1000 from about 650 in a little over 6 months. Too far, too fast.
A reversal was expected and the recent declines do nothing to reverse
the uptrend.
Gold’s
rise has been in response to the Dollar’s decline. The recent
action by the Fed has given some strength to the Dollar.
But the recent
strength has not been enough to reverse the Dollar’s long
term downtrend.
The Dollar’s
decline has been in response to inflationary policies by the Fed.
Lowering interest rates and flooding the markets with liquidity
only stoke inflation further. The Dollar’s decline is not
any where near over in our opinion and as indicated by the chart
above.
Oil
has had a very bumpy ride for the past few weeks. Some even point
to the recent failure to make a new high as a sign that oil’s
bull market is over.
Looking at the
longer term chart of oil you can see that it also went too far,
too fast. A pullback was expected and a drop to 90/bbl shouldn’t
surprise anyone. A pullback to 80/bbl might even be in the cards.
A price decline
doesn’t change the fundamentals of increasing demand with
limited supply. (Which adds up to higher long term prices for oil.)
It gives us a buying opportunity.
Above is a chart
of Oil Stocks. Curiously, it was up yesterday while the price of
oil was flat.
The longer term
chart for Oil Stocks shows that they peaked and declined well in
advance of oil itself. They seem to have double bottomed recently.
This could be setting up a sideways trading range or, if it fails
at about 1325, a new leg down. A rise above the 1425 area could
signal a breakout for oil stocks.
With fundamentals
on their side, erring on the side of bullishness is warranted.
The Oil Services
index may have broken out of its trading range yesterday and a move
above 290 would confirm this. Still a drop to 260 or even 250 wouldn’t
surprise me.
What does all
this mean for investors?
First, bear
markets have rallies. They can prematurely get investors excited
that whatever ailed the economy is behind us. People that get caught
up in bear market rallies can get hurt very badly.
Second, bull
markets have pullbacks. I know this sounds pretty basic, but investors
tend to forget this stuff. No bull market goes straight up, no matter
how good the story. So even though commodities, oil and gold are
cornerstones of our portfolios, we expect to see them bounce around
quite a bit. That doesn’t change the fundamentals of their
increasing demand and limited supply scenario though. Long term
is still up.
Third, this
is why you have professional management. We don’t get caught
up in the emotions of the day. We stay focused on the long term
and we question everything.
And lastly,
this is why our investment style and strategy is not mainstream
or like Wall Street’s. We do not hail the Fed’s plans
as a panacea. We see the long term damage it does. We are not tied
to only stocks and bonds. Instead we have broadened our scope of
investment choices to include commodities, international equities
and market hedges that are in or entering bull markets.
We continue
to focus on fundamentals, not short term market moves.
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